The Paradox of Wealth and Poverty - Research Paper Example

The Paradox of Wealth and Poverty Globally, the economic development of a nation is generally measured in terms like the Gross Domestic Product (GDP) or the Gross National Product (GNP). It has been evidently observed across nations that even though there has been an increase in the GDP of economies, there has been little or no change in the economic progress of the lower income population. This happens due to an inequitable distribution of wealth amongst the citizens of the economy and therefore, even when the nation is said to have become wealthier according to the generally accepted measures, a significant portion of the population actually become poorer day by day. This gives rise to a paradoxical situation in which wealth and poverty simultaneously increase in an economy. An attempt in recent years to find a solution to this globally prevalent problem has been the made by nations by implementing the concept of “Microfinance”, which ensures provision of a wide range of financial services to the very poor. One of such most important financial services is the issue of “microcredit” to the poor, who are usually unable to get financial support from the conventional credit system due to a number of reasons. This revolutionary financial innovation originated with the establishment of the Grameen Bank by Muhammad Yunus, winner of the 2006 Nobel Peace Prize, who had started working on this issue back in the year 1976. This concept is today being applied in the developed countries like the U.S. as well, where around 37 million people (12.6%) live below the poverty line (Wikipedia). However, it has been observed that replication of the original Grameen Banking model internationally is a very challenging task and large scale implementation of the concept may not be entirely possible. But given the promising results that this microcredit concept has shown, nations all over the world are trying to come up with policies in order to apply the concept to their respective economical and socio-cultural set up. In this essay, I’m going to describe the problem of economic and social inequality that microfinance seeks to address, and then explain in detail the concept of microfinance and microcredit, how did the concept originated in the first place, the philosophy behind this concept that seeks to solve the globally prevalent problem of economic inequality, the international replications of the concept and finally the present day performance of the policy and the various challenges that are in store for the nations seeking to apply it on a large scale. The problem under consideration: In the last few decades, the world has witnessed tremendous economic growth. However, there has been a discrepancy in economic development at two levels. Firstly, certain parts of the globe have been able to accumulate much greater wealth than the other parts. Thus, regions like the sub-Saharan Africa, south-east Asia and Latin America have been left with high levels of poverty. Secondly, even in the other “wealthier” parts of the globe, it has been observed that a major amount of wealth is accumulated in the hands of a few citizens, while a significant portion of the economies is seen to be struggling to make ends meet. Estimates suggest that approximately 1.2 billion people live in extreme poverty or on less than approximately $1 a day (adjusted for purchasing power parity across nations) and an additional 1.6 billion live on approximately $1 to $2 a day. (Susanna, Khavul August 2010) There are two major factors that prevent this significant portion of the world population from coming out of the vicious circle of poverty. Firstly, in the last few decades, several trillion dollars have been spent on public driven initiatives. But these programs have typically taken a top-down approach, wherein a little of the funds allocated trickles down to the poor. Instead, what is required is a bottom-up, entrepreneurial approach that can lead to increase in productivity and thus can result in an actual rise in the wealth of the poor. The second important factor takes into consideration the access to financial capital by the poor, that comes either from savings or from borrowings. Since the poor are highly vulnerable to various external factors, if at all they are able to accumulate any savings, there is a very high chance of the savings getting depleted. Now the alternative they are left with is borrowing. The traditional financial institutions find it very risky and costly to lend to the poor, due to their low creditworthiness and absence of or very limited collateral. The only option they are left with is to borrow from moneylenders which only makes their problems worse due to very high interest rates. Microfinance takes into consideration the above two major factors along with other factors and seeks to address the problem of inequality by resorting to financial innovation techniques. Additionally, the original concept of microcredit, which is perhaps the most important part of microfinance, also strives to address the issue of gender discrimination in developing countries. Notably, 97% of the Grameen Bank’s clients are women. (Grameen Bank, 2010) Definition of Microfinance and its working : Microfinance is a type of banking service that  is  provided to unemployed  or  low-income  individuals or groups who would otherwise have no other means of gaining financial services. Ultimately, the goal of microfinance is to give low income people  an opportunity to become self-sufficient by providing a means of saving money, borrowing money and insurance. Although most modern microfinance institutions operate in developing countries, the rate of  payment default for loans  is surprisingly low - more than  90% of loans are repaid. The World Bank  estimates that there are  more than  500 million people who have  directly or indirectly benefited from microfinance-related operations. (Investopedia). These operations offer a range of financial instruments including credit, savings, mortgages, insurance and retirement plans, all of which are denominated in small amounts. Of these, the most widespread instrument is the microcredit or microlending, which is the issuance of small and unsecured loans to individuals or groups, for the purpose of starting or expanding businesses. Typically, the way microcredit works in many regions is that the borrowers are formed into groups which are called as self-help groups in certain regions. Initially, one or two members of the group are given loans for their entrepreneurial / income-generating activities. It is only when the two initial borrowers of the group fulfil their obligations that the other members are further loaned amounts. In case one of the member defaults in fulfilling his loan obligation, the entire self-help group discontinues to receive any further credit assistance. It is this peer pressure that ensures a very high recovery rate. It is also important to understand that these loans are supposed to be disbursed amongst people who make use of the credit in order to earn a livelihood and thereby live a better life. So, even in the absence of collateral security, the recovery rate is very high owing to the fact that one may not be as much affected when one loses one’s collateral security, as one is when one loses his / her entire livelihood by defaulting in the fulfilment loan-repayment obligations. Hence, subject to the proper management of the scheme and to the fact that the scheme is targeted at those who need it the most, the concept of microcredit can go a long way in creating opportunities to achieve its goal of alleviating poverty and bringing about economic and social equality. The History of Microfinance: The history of microfinancing can be traced back as long to the middle of the 1800s when the theorist Lysander Spooner was writing over the benefits from small credits to entrepreneurs and farmers as a way getting the people out of poverty. But it was at the end of World War II with the Marshall plan, when the concept had a big impact. (microfinanceinfo.com). Similar efforts have been made since then in the area of microfinance, but it was only in the year 1976 when Muhammad Yunus began to work on the problem of economic and social inequality in a small village called Jobra in Bangladesh that the modern movement of microfinance had just begun to gain momentum. It was in the year 1974 when famine conditions arose in Bangladesh that Mohammad Yunus got greatly involved in working with the people of the Jobra village and trying to come up with solutions for their problems. He did various experiments, one of them being the “three-share farm experiment” to help the famine struck village. Although his experiments were successful, he realized that they were doing no good to the poorest inhabitants of the village who needed the most help. It was then that he came up with the idea of lending some money (856 taka or $27 ) to around 42 people to help them use their skills and sell their products in the market, rather than operating via the middlemen, who used to take undue advantage of their situation. Thus began the journey of the establishment of the Grameen Bank, which later evolved into the global concept of microfinance. The period of 1976 – 1978 was the experimental phase of the Grameen Bank, when among other things, they learnt that the recovery of loans is much faster and better assured when the loan is given to women rather than men. They also experimented with different methods of repayment mechanism and finally decided upon the most efficient one. This was followed by long discussions with traditional financial institutions to make them understand and accept the concept of microcredit. Finally, on the second of October, 1983, the Grameen Bank Project became a separate corporate entity called as the Grameen Bank. Since then, it has set an illustrious example in front of the entire world. The amount of $27 that Muhammad Yunus had personally loaned to some inhabitants of the Jobra village has now increased to a loan amount of around $9.1 billion disbursed in a number of countries in a period of around 30 years. (Grameen Bank, 2010) The Philosophy behind the Concept: While explaining the philosophy behind the concept of Grameen banking and microcredit in his book titled “Banker to the Poor”, Muhammad Yunus explains, “Opening up opportunities for self-employment by creating appropriate institutions and policies is unquestionably the best strategy for eliminating unemployment and poverty. --- By missing the lively world of self-employment, the ‘science’ of economics has moved away from the promise it once held of becoming an exciting social science. Instead, it has grown more and more into a business science.” The micro-economic theory, in which the individual human is introduced as a consumer in the consumer theory, and as a laborer in the production theory, misses the role of an individual as an entrepreneur. Entrepreneurs have been considered as a few gifted individuals under whose command the rest of the individuals are supposed to work. The Grameen banking concept refuses to accept the economic theory in which dealing with poverty is almost a missing issue. This Grameen banking concept, from which has evolved the concept of microfinance, appreciates the central thesis of a free market capitalist economy, i.e. the economic system must be competitive, since it is competition that is the driving force behind innovations, efficiency and a better management. However, the original concept of microfinance is not in sync with another central feature of capitalism, i.e. profit-maximization. The economic theory views an entrepreneur as only a profit-maximizer. In fact, in some developed countries of the world, the corporate law compulsorily requires corporates to aim only for profit maximization, rather than using a part of the funds for the welfare of the society, in which case the shareholders are entitled to sue an executive or the board of directors. Instead, what Muhammad Yunus proposes is that an entrepreneur should aim to maximize a bundle of two components, viz. profit and social returns, subject to the condition that the profit is not negative. The entrepreneur then will have a range of options for his investment decisions. On one hand, he may take decisions purely guided by the motive of profit maximization and on the other extreme side of the spectrum of decisions, he may look for maximizing the social benefits as long it is financially viable for him to do so. It is on this principle of “social-consciousness-driven capitalism” that the whole philosophy of Grameen banking and microfinance has been based. The concept demands that the responsibility of the welfare of individuals should be transferred from the governments to the private sector, but with an added element of social-welfare instead of profit-maximization, which is currently not the case. International Replications: The replication of the concept of the Grameen Bank requires the reproduction of its essential features in the different economic and socio-cultural set-ups. Two of these fundamental features are the most important in the replication of the concept. One, there should be no compromise on the target population. The Grameen concept says that the focus of any microfinance institution should be on the bottom 25 per cent of the population, particularly the poorest women. Second, the recovery rate should be almost 100 per cent. In the last twenty years, the Grameen ideas have been reproduced in Africa, Asia, Europe, as well as in North America and South America. While cultural, geographical and climatic conditions differ, the problems of the poor are similar all over the globe. As Muhammed Yunus has mentioned in his book, the Grameen concept has near universal applications and it does not require the culture of Bangladesh to succeed. Let me now describe how the Grameen concept has been replicated in South America as well as in North America. Replication of microfinance in South America: Many microcredit organizations are working in the Central and Latin America. Muhammed Yunus, has mentioned in his book, “Banker to the Poor ”, Accion, the largest of the microfinance organizations in south America has a network of around twenty-five affiliated organizations working in thirteen Latin American countries and six US cities. In a period of seven years from 1991 to 1997, Accion was able to disburse around $1.7 billion in loans, averaging in around $600 to more than 1.3 million micro-entrepreneurs. Besides, other microcredit networks such as FINCA – Foundation for International Community Assistance - and Katalysis which are doing significant work in the field of microfinance in Latin America. Besides, some important replications are promoted by the Grameen Foundation USA, which target the poorest people in Latin America. Replication of microfinance in North America: Some people argue as to why is microfinance needed in a developed region like the USA. One has to understand that poverty is much more difficult to bear in a relatively affluent society. Besides, as mentioned earlier, irrespective of the cultural, economic and social differences, the poor people all over the world face similar problems. There are more than fifty Grameen-type micro facilities in the US. For instance, the Calmeadow foundation in Canada has initiated exciting microcredit facilities on Native American reservations. Another organization named Working Capital gives loans to existing entrepreneurs who lack the funds and other support facilities. It has also started franchises in South Miami and Delaware. Their performance has been quite well and their recovery rates have also been very encouraging. One of the first stepping stones towards the establishment of microfinance in the US was the formation of the Women’s Self-Employment Program (WSEP) in Chicago. Since then WSEP has disbursed much more than a million dollars to more than 300 businesses in Chicago and has also given counseling services to more than 5000 women. One of the first programs launched by the WSEP was the Full Circle Fund (FCF) in 1988. The FCF encouraged economic development in depressed communities by disbursing loans of $300 to $1500 each to women entrepreneurs who agreed to work in a group of five. Everyone argued that the five-women group idea would not work because the Americans are too independent. However, against all the criticisms, the idea worked very well, thus reaffirming the fact that the Grameen concept is near universal. Since then till now, many such microfinance programs have been initiated in the US. However, they still have a long way to go and the fact that microfinance will be successful in achieving its goals in the US in the present scenario is a debatable issue. The Question of the Success of Microfinance in America: The Grameen enterprise that works in the U.S. is called as Grameen America. By coming to the U.S., Grameen has taken a different sort of challenge. This is due to the nature of the developed economy which currently has around 100,000 bank branches. Presently, around 9 million U.S. households are untouched by mainstream banks (Kiviat, Barbara November 2010). Grameen America, among other microfinance institutions, is taking steps to solve the credit requirement problems of these households. Currently, its repayment rate is around 99% in the U.S. Since 2008, Grameen has disbursed loans to around 1,700 borrowers in the New York city and has opened new branches in other cities as well. However, the fact that inspite of years of making loans to small and startup enterprises, Accion, another microfinance organization in the US has still not been able to become profitable, it is evident that the challenges that lie ahead of Grameen America and other similar organizations are huge. In the U.S., Accion has probably got closer to self sufficiency than any other microfinance organization. Accion Texas now underwrites loans for twelve different microfinance organizations. However, unlike Accion and most other microlending enterprises in the U.S., Grameen’s approach is different. The difference lies in the fact that Grameen America uses group-lending model. Whatever be the approach be, empirically, it can be said that the task that lies ahead of the microfinance institutions in the U.S. is the most challenging one. Microfinance as of Today and its Evaluation: Currently, more than half of the world population does not have access to banking or other financial services (Beck, Demircug Kunt). Today, the majority of microfinance is aimed at an estimated 2.8 billion people who live on less than $2 a day in the developing world. Additionally, an increasing amount of microfinance is also being offered in the developed countries. With the concept getting greater recognition year by year, a number of diverse microfinance organizations have been established. Most of them are private organizations or involve public-private partnerships. There has been an increasing trend in the number of for-profit organisations in the microfinance field (Battilana and dorado, 2010). This has led to an enormous increase in the supply of microcredit. There are approximately 100 private equity funds that manage close to $6.5, that are currently channelizing money towards the microfinance institutions (Khavul , Susanna August 2010). Having said that, with such a huge amount that is currently being used for a number of microfinance operations all over the world, it is a matter of debate if microfinance is actually doing well to alleviate poverty or not. There are a few important factors that should be taken into consideration while evaluating the effectiveness of the model in the present scenario, viz. the loan repayment rates, the impact on the empowerment of women especially in developing countries and the changes in the quality of lives of the borrowers. Let me consider each of these factors individually. Loan repayment rates: Loan repayment rates are the single most watched indicator of the performance of microfinance institutions. Since the inception of the Grameen bank, this loan repayment indicator has performed very well. However, recent studies of the performance of the microfinance institutions all over the world have raised concerns regarding the repayment of loans. The argument widely has been that borrowers may be taking out additional loans from different microfinance institutions to pay their initial loans, thus artificially increasing repayment rates. The Grameen Bank follows a transparent policy and has been regularly posting its repayment rates on its website. If we look into the repayment rates of the Grameen bank from the year 2002 till the year 2009, we can observe a decline in its repayment rate from around 98.25% to around 96.5%. Now although in absolute terms, the repayment rate in 2009 seems to be healthy, it is a matter of high concern for the Grameen Bank. The reason for this is that almost perfect credit repayment is a fundamental requirement for the success of the concept of microfinance without which loans cannot be given to borrowers who don’t have a high credit worthiness in terms of traditional rules. This becomes particularly important when the overall amount of loans has increased multifold over the years. In the words of Muhammad Yunus himself, “one must remember right from the beginning that if the recovery rate is not near 100 per cent, no matter how good it looks, it is not Grameen. All the strength of Grameen comes from its near-perfect recovery performance.” (Yunus, Muhammed 1998). Additionally, it can be observed from the figures posted by the Grameen Bank on its website that the repayment rate has steeply declined all of a sudden in the recent few months. To make the situation more grave, this recent higher level of default in repayment of loans is also seen other developing countries like India, which is one of the largest players in the field of microfinance. Indeed, it is highly suspected that multiple borrowing, i.e. borrowing from a second lender in order to repay the first lender, is widespread in Bangladesh as well as in other developing countries now, and it has raised concerns that the microcredit loans are being juggled the way some Americans have been juggling credit card debt. Thus, there is a worry that we may be in the midst of a microcredit bubble. This raises concerns about the continuation of disbursement of high amounts of microfinancing and thus questions the very capability of the model to eradicate the high levels of poverty being witnessed by the world. Although repayment rate is rightly given prime importance in the evaluation of microfinance institutions, it must be understood that there are other related factors that cannot be overlooked while evaluating the performance of these institutions. In fact, it may actually be misleading to evaluate their performance basis the repayment rates without considering the other related factors. One such important factor is the performance of the overall economy. Ahlin et al. recently proved that the macro-economic factors do have an impact on the sustainability of the microfinance institutions. They benefit from a robust national economy in terms of cost recovery and growth. Similarly, the underlying business performance also has an impact on the sustainability of the microfinance institutions, which should be looked into along with repayment rates. Empowerment of women: The empowerment of women has been seen as an important social goal of microfinance. As mentioned earlier, the Grameen Bank data states that 97 per cent of Grameen’s clients are women. In fact, in the recent Clinton Global Initiative in New York city, Muhammad Yunus defined microfinance as lending money to the poorest women for income generating activity, without collateral, so they can help themselves out of poverty. Observers, however, argue that this goal of women empowerment is illusive. A majority of women who take loans in developing countries like Bangladesh and India do so at the request of their husband. Additionally, some microfinance organizations make the male family members cosign initial loan applications, thus keeping them completely involved in the whole process. Even if a woman starts a business with the help of a microfinance loan, she rarely has complete control over the proceeds that come from the business. To add to this, it was observed in a study that microfinancing clients did not show any greater considerable improvement in health, education, or women’s empowerment when compared with a neighborhood without a microfinance branch (Banerjee et al. 2009). However, it has been observed in certain regions that microfinance empowers the women outside the household by fostering the ability to take collective action. Thus, the fact that microfinance helps substantially in the area of empowerment and independence of women is a doubtful proposition. Impact of microfinance on the lives of borrowers: As mentioned earlier, the philosophy behind the concept of Grameen banking and microfinance is based on social-consciousnessness-driven capitalism, that promotes entrepreneurship as a way of earning a livelihood. It is therefore important to evaluate the microfinance policy in terms of small business profitability and investment. In a study done by Banerjee et al., it was observed that researchers conducted an observational experiment on 104 neighborhoods in Hyderabad, India. They conducted a baseline consensus of the neighborhoods and compared borrowing patterns of households who had access to microfinance credit with the borrowing patterns of those who did not have access to microfinance credit. It was observed that there were 32 per cent more businesses in the areas where microfinance credit was available. They were also observed to be making relatively higher monthly profits than those who did not have access to microcredit. This was accompanied by shifts in composition of consumption patterns in the areas having access to microcredit. This gives a new direction to the evaluators of microfinance. Although the repayment rate is of great importance in evauluating the performance, the actual impact of microfinance on the lives of the borrowers is also equally important. This can justified by the fact that a number of borrowers, due to peer pressure or other reasons, end up finding ways of repaying the loans, even if there has been no much positive impact of availing the microcredit facility to their businesses. Conclusion: Microfinance has been observed by many as the long-sought solution to the problem of ever prevailing poverty. However, the above analyses shows that with the increasing amounts of loan disbursements, the entire premise of microfinance can be questioned. In essence, microfinance is about building domestic financial markets that serve their poor majorities. What microfinance needs is better aid, not more aid. Building domestic markets and local intermediation capacity between savers and borrowers requires more technical and managerial inputs than financial ones. Especially in the last few years in the developing countries, it has been observed that much of the money disimbursed by microlending institutions has not been very effective and sometimes has in fact been destructive of local markets. It is much more important to improve the effectiveness of that aid rather than increasing it multifold. Having said that, it has been clear for many years now that microfinance is becoming increasingly integrated in the much broader world of mainstream markets and financial systems. The aim for the future is the development of deep domestic financial markets with sound and healthy financial institutions that serve the majority of the poor population. Future sources of funds will be mainly domestic savings, and the role of financial intermediaries is to provide critically important deposit services, recycling these savings into productive loans for the poor. However, in order to do that, one needs to understand what will the composition of the future population be like. One needs to understand who the future clients will be. Given the staggering numbers of young people growing up in developing countries and the aging populations of the developed nations, our client base of the future will be very different than that of today. Two and a half billion of todays world population are children and teenagers who will become adults during the next decade or two. I believe that one critical aspect that will impact the way microlending institutions will function is the change and advancements in technology, especially in the developing world. Among all new technologies, the wireless technology promises to radically reduce transaction costs and the possibility of anytime, anywhere access by even very poor and remote clients. The two-billionth cell phone had already hit the market a couple of years ago. It took 12 years to reach the first billion, but only two and a half years to reach the second. And a large portion of the second billion went to the developing countries. This means that in the coming wireless world, corner grocers, petrol stations, and lottery outlets with cell phones can become points of sale for financial and other services. In the Philippines, Senegal, South Africa, and Kenya, experiments using cell phones for financial transactions among previously excluded populations are already showing positive results. The use of wireless technology could mean sudden, massive access opened up for poor, low-income, and remote people. Alternatively, technology could become the principal fad and focus of microfinance and donors, leaving some people behind. A new digital divide, at a lower level of poverty, could be created that is even more intractable than today. The world has been facing the problem of the paradoxical simultaneous increase in the wealth and poverty since many years now. The more one tries to get deeper into this problem, the more complicated the problem gets. Any solution offered to solve the problem cannot be said to be the perfect solution. It will have its own limitations and the fact that we are living in such a dynamic environment, the solution that works perfectly today may become obsolete tomorrow. Microfinance is no exception. As a concept it is very promising. After all, it has the appeal of bringing the financial power to the people who need it the most. But as a policy, it is very difficult to implement. Microfinance has already started facing the problems of large-scale implementation, even though it has not even covered the tip of the iceberg of poverty. The need of the hour is to look into these problems, so that the weapon of microfinance can be most effectively used in attacking the long prevalent issue of poverty and in achieving the goal of equality. Works Cited Ahlin, C., Lin, J., & Maio, M. Where does Microfinance flourish? Journal of Development Economics. Web. 1 December 2010. Bahree, Megha. A Big Split over Microfinance. Forbes Asia, Oct 2010, Vol 6, Issue 12, p 18 -19. Web. 1 December 2010 Banerjee, A., Duflo, E., The Miracle of Microfinance? U.S.; 2009: Web. 2 Dec 2010. Battilana, J., & Dorado, S. Building Sustainable Hybrid Organisations. Academy of Management Journal. 56 (6). Web. 3 Dec 2010. Beck, T. & Kunt, A. Banking Services for Everyone? The World Bank Economic Review. 22(3), 397-430, Web. 3 Dec 2010. Grameen Bank: Bank for the Poor ; Grameen Bank: 2010. Web. 29 November 2010. Investopedia. Microfinance. Investopedia US, A Division of ValueClick, Inc. n.d. Web. 29 November 2010. Khaval, Susanna. Microfinance: Creating opportunities for the Poor. Academy of Management Perspectives, Aug 2010, Vol 24, Issue 3, p 58-72. Web. 1 December 2010. Kiviat, Barbara. Can Microfinance make it in America. Academic Research Elite. Vol. 175, Issue 1, p36-37, Web. 30 November 2010 Wikipedia. Microfinance. Wikimedia Foundation Inc. 2010. n.d. 29 November 2010. Yunus, Muhammed. Jolis, Alan. Penguin Group. New Delhi. India. 1998. Print. .       .  Read More